Eric,

I would say that the belief about inflation expectations moving is justifiable – as its a psychological device that we just don’t really understand well at the moment. My post was just trying to work the angle that the RBNZ knows this, and will respond appropriately.

I agree with Seamus about some of the holes in my description as well – it is good having people heading through things.

Hi Seamus, great points.

I agree that I worded it poorly to start with – the target should be potential, not ex-ante output which is how it sounded from what I wrote.

“I’m not sure of your reasoning here. A negative supply shock is the opposite of a positive demand shock in terms of the impact on policy, as both imply opening up a postiive output gap, and hence both imply a policy response of monetary tightening to keep output at potential.”

You are right here – I think my thinking was off.

In essence I was writing with this feeling that the demand side of the economy would endogenously respond – and now that I think about it, I can’t see any ex-ante reason to believe that.

Update I think that I was working off the implicit logic that “a positive terms of trade shock had lead(at least in their explanation of it) to them increasing rates more quickly – so a negative terms of trade shock should do the opposite. What I ignored is that one was because of an increase in export good prices while this one is due to an increase in “import” prices – so the price shocks involved were very different.

I am with you on this one. Eric is worried that as the economy grows, the quota price in the ETS will keep rising, and so be a series of price shocks. But a price shock is only a concern for a central bank to the extent that an unexpected change in a major price coupled with sticky prices in general imply that the relative price change brings with it a shock to the aggregate price level initially, leaving the Bank with the question of whether to accommodate or not. Here we are talking about small, expected, increases in the relative price of carbon-intensive goods over time, which is just part of the normal churning of relative prices.

But I disagree with you on a couple of points. First,

MN: “If we have a net liability under the Kyoto protocol this would be equivalent to a negative terms of trade shock (something I would term a negative supply shock) – so the Bank would optimally want to partially accomodate that (given their implicit quadratic loss function).”

Quadratic loss functions minimise a weighted-sum of squared deviations of inflation from target and output from potential. In the case of a simultaenous negative supply shock and positive price shock, actual output needs to decline to keep output at potential, so the loss-minimisting strategy is to not accommodate the shock price shock. Indeed, if the price shock fuels inflation expectations, the Bank should force output even lower than the shock to potential.

Second,

MN: “If anything, the common belief that we will end up with a liability as a nation (when all the figures are finally together) implies that Bank policy should respond by EVEN LESS than it would in the face of a compensated relative price shock – as it is a negative supply shock.”

I’m not sure of your reasoning here. A negative supply shock is the opposite of a positive demand shock in terms of the impact on policy, as both imply opening up a postiive output gap, and hence both imply a policy response of monetary tightening to keep output at potential.

Hi Ben,

Thanks for the kind words.

“When I hear value judgment, I think ‘arbitrary’.”

I can see what you are saying – but in the sense I’m using value judgment it isn’t an arbitrary belief per see, just a belief where there exists no undeniable fact. Keeping in mind when I make a value judgment – even if I happen to have some experience with making these judgments in this specific case – is important.

Ultimately, I like the difference to be clear so people can compare it to the way they think about things and update their beliefs or disagree with me. When we have a situation where we can transparently do that I think it adds value to everyone involved – it definitely provides me with useful knowledge from other people.

I agree with your conception of value judgments, and the fact that people can “add value” by discussing them. Given that they are required for reaching conclusions, an educated value judgment is extremely valuable. In no way do I mean to use the term in a derogatory fashion – in essence the value judgment is an incredibly valuable part of any analysis. It is so valuable, that I would feel bad if I did not point out where they appeared – I would feel like I was using economic language to obscure the truth, something all economists can inadvertently be guilty of at times.

However, I would almost certainly place much more weight on your opinion than my butcher’s about how the Reserve Bank thinks about the effects of GST and ETS, and it isn’t because your values are better. It’s because your guess is more educated in this space. You probably know people at the Bank, you’re trained in the same discipline as them, you know the rules they operate under, and you’ve been watching them for years. I imagine you have a good idea of what their pain is. Your guess is, in other words, not arbitrary, which is what a value judgment is.

A guess is not a value judgment to the extent it is informed by something other than your personal values. In this case your experience and expertise surely has strong bearing on your opinion? (I hope so, that’s why I read TVHE) Experience and expertise are not values (although reasonable people will take the same data and often disagree). In fact they are scarce goods that probably explains a good part of why some blogs get read and others don’t, and why academics and consultants attract a premium wage.

I guess the reason this sort of thing gets my goat a bit is because value judgments are what shysters – which you most definitely are not – hide behind when somebody points out that their analysis is incoherent and at variance with all mainstream theory and available evidence (I’m thinking of BERL on alcohol, for example). I think you sell yourself short with the sort of moral relativism that is implied by terms like value judgments. You have skill and experience that is scarce, and objectively valuable in that those skills can be used to explain something about the world that is not obvious and interesting to a lot of people.

My two cents 🙂

Also I would note that having conclusions that follow from premises is a necessary condition for an argument for sure. However, it is not sufficient to make the conclusion objective – as some priors will likely need to be subjective.

At some level ALL priors are subjective – “objective” in the sense I use it is just the underlying set of points that people are willing to agree upon given their own realities.

My economics was identifying the combination of the ETS and Kyoto as a negative supply shock that occurs specifically as a relative price movement (that is what the ETS does for it). In this sense, it is similar to a spike in oil prices. This is the most objective bit.

Then I try to be descriptive about the Bank. In the same way that the Bank would not directly treat a rising relative price of fuel as something it needs to respond to – it is not going to treat rising relative permit costs as something it needs to respond to, unless it feeds into inflation expectations.

My value judgment given these descriptive elements was that I agree with this action as I don’t think inflation expectations will move – or I at least agree that the best ex-ante assumption is that inflation expectations will not move. If I hadn’t made that judgment, I would not have been able to say I agree.

The primary value judgement is that persistent relative price shifts don’t flow into inflation expectations. I have to make a judgment here as the process of belief formation regarding future inflation is an unknown psychological variable.

The point of economic analysis is to frame the situation – it tells us that inflation expectations are the central issue in this specific case. Given that I have to apply my beliefs in order to reach a conclusion regarding what the ETS means for RBNZ policy.

What I am saying is your conclusion here is not a value judgment. It actually does follow from your priors and are a product of reason. This matters because it is objective analysis not personal values which are capable of explaining things.